Department of Applied Economics Johns Hopkins University

Economics 602
Macroeconomic Theory and Policy
Final Exam Suggested Solutions
Professor Sanjay Chugh
Spring 2009

NAME:

The Exam has a total of four (4) problems and pages numbered one (1) through thirteen (13)
(followed by three blank pages for any scratch work). Each problem’s total number of points is
shown below. Your solutions should consist of some appropriate combination of mathematical
analysis, graphical analysis, logical analysis, and economic intuition, but in no case do solutions
need to be exceptionally long. Your solutions should get straight to the point – solutions with
irrelevant discussions and derivations will be penalized. You are to answer all questions in
the spaces provided.

You may use two pages (double-sided) of notes. You may not use a calculator.

Problem 1 / 25
Problem 2 / 25
Problem 3 / 35
Problem 4 / 20
TOTAL / 100
Problem 1. M1 Money and M2 Money (20 points). Consider an extended version of our
infinite-period MIU framework. In addition to stocks and nominal bonds, suppose there are two
forms of money: M1 and M2. M1 money (which we will denote by M t1 ) and M2 money (which
we will denote by M t2 ) both directly affect the representative consumer’s utility. The period-t
utility function is assumed to be

⎛ M1 M 2 ⎞ M1 M2
u ⎜ ct , t , t ⎟ = ln ct + ln t + κ ln t ,
⎝ Pr Pt ⎠ Pt Pt

which, note has three arguments. The Greek letter “kappa” (κ) in the utility function is a number
between zero and one, 0 ≤ κ ≤ 1 , over which the representative consumer has no control. The
period-t budget constraint of the consumer is

t t + M t + M t + Bt + St at = Yt + M t −1 + (1 + it −1 ) M t −1 + (1 + it −1 ) Bt −1 + ( St + Dt ) at −1 ,
M
Pc 1 2 1 2

where it denotes the nominal interest rate on bonds held between period t and t + 1 (and hence
it −1 on bonds held between t − 1 and t ) and itM denotes the nominal interest rate on M2 money
held between period t and t + 1 (and hence itM−1 on M2 money held between t − 1 and t ). Thus,
note that M2 money potentially pays interest, in contrast to M1 money, which pays zero
interest.

As always, assume the representative consumer maximizes lifetime utility by optimally choosing
consumption and assets (i.e., in this case choosing all four assets optimally).

a. (4 points) Using the functional form for utility given in this problem, what is the
marginal rate of substitution between real M1 money and real M2 money? (Hint:
You do not need to solve a Lagrangian to answer this – all that is required is using the
utility function.) Explain the important steps in your argument.

Solution: As always, the MRS is simply the ratio of marginal utilities. The marginal utility
1/ Pt
function with respect to M1 is , and the marginal utility function with respect to M2 is
M t1 / Pt
κ / Pt
(note that you had to use the chain rule to properly compute these marginal utilities).
M t2 / Pt
M t2
Constructing the ratio of these and canceling terms, we have the MRS is (i.e., this is the
κ M t1
slope of any indifference curve over M1 money and M2 money).

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Problem 1 continued
b. (4 points) A sudden, unexplained change in the value of κ would be interpretable as
which of the following: a preference shock, a technology shock, or a monetary policy
shock? Briefly explain.

Solution: The parameter κ , as we saw in part a above, affects the MRS between two of the
arguments to the utility function (M1 money and M2 money). A change in κ thus affects the
slope of the indifference curve, and thus is interpretable as a preference shock.

c. (12 points) Let φ 2 ( ct , it , itM ) denote the real money demand function for M2 money. Note
the three arguments to the function φ 2 (.) . Using the first-order conditions of the
representative consumer’s Lagrangian, generate the function φ 2 (ct , it , itM ) (i.e., solve for
real M2 money demand as a function of ct , it , and itM ). Briefly explain (economically)
why itM appears in this money demand function. (Note: you must determine yourself
which are the relevant first-order conditions needed to create this money demand function –
draw on our approach from Chapter 14.)

Solution: Construct the lifetime Lagrangian as usual, and compute the first-order-conditions
with respect to ct , Bt , and M t2 (the FOCs on M t1 and at turn out to be irrelevant in this
problem):
1
− λt Pt = 0
ct
−λt + βλt +1 (1 + it ) = 0
κ / Pt
− λt + βλt +1 (1 + itM ) = 0
M / Pt
t
2

Substitute the FOC on consumption and bonds into the FOC on M2 money to get, after several
algebraic rearrangements,

M t2 κ ct (1 + it )
= .
Pt it − itM
Note that this is very similar to the “usual” money demand function obtained when utility is
logarithmic (in our “usual” model we implicitly had κ = 0 and itM = 0 ).

The interest rate itM appears in this money demand function simply because there is an interest
benefit of holding this asset, as opposed to no interest in M1 money. As the above money
demand function shows, the larger is itM , the larger is M2 money demand. Think of M2 as a
savings deposit against which you can write checks, and M1 money as cash. Cash earns you
zero interest, whereas a savings deposit earns you some positive interest; on the other hand, cash
is accepted everywhere, but checks against your savings deposit are not accepted everywhere
(i.e., savings deposits are less liquid than cash).

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Problem 2. Monetary Neutrality or Nonneutrality? (25 points). Suppose firms need to use
only labor in order to produce output, and output in period t is given by yt = At nt , where At is a
technology shock and nt is the number of hours of labor. Firms choose their labor in a profit
maximizing way every period. Suppose the representative consumer’s period-t utility function is
M
given by ln( Bt ct ) + ln lt + ln t , where, as always, lt = 1 − nt denotes leisure, Bt denotes a
Pt
preference shock, and M t / Pt is real money. Note that rather than supposing there are “168 units
of time” available, here we are supposing that there is only “one unit of time” available (hence,
both n and l will be fractions between zero and one). Finally, assume the labor supply curve is
always upward-sloping (i.e., it never bends backwards), and that the labor tax rate is always zero.

a. (7 points) In the diagram below, show the effect on the consumer’s optimal choice of
consumption and leisure in period t due to a simultaneous rise in At and rise in Bt . Clearly
label your diagram, and explain precisely any and all effects pertinent here.
consumption

Solution: With the representative firm maximizing profit, we know that the real wage equals
the marginal product of labor. In this case (with the linear production technology), the
marginal product of labor is simply At , which means the slope of the budget line in the above
diagram (which is the real wage) is At . The rise in At means the budget line becomes
steeper, pivoting around the fixed point on the leisure axis.

Next, consider the MRS between consumption and leisure. We know the MRS between
consumption and leisure (i.e., the slope of the indifference curve) is ul / uc . With the given
utility function, ul = 1/ l and uc = B /( Bc) = 1/ c . Note that the B term drops out of the
marginal utility of consumption here (you had to use the chain rule to fully differentiate).
Thus, the MRS is unaffected by the preference shifter in this case, meaning the indifference
map is unaffected.

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Problem 2 continued
b. (7 points) Suppose instead of the preference and TFP shocks in part a, there were a positive
money shock (and no other shocks) at the end of period t (as we described in class – i.e., the
actual M t turns out to be different than the “planned” M t ). Suppose both nominal prices
and nominal wages are completely flexible. In the diagram below, sketch the effect on the
consumer’s optimal choice of consumption and leisure in period t due to the surprise extra
quantity of money in the economy. Clearly label your diagram, and explain precisely any
and all effects pertinent here. (Hint: The consumption-money optimality condition is
relevant for the analysis here.)
c.
consumption

initial optimal
choice

leisure
Solution: Recall the consumption-money optimality condition with log-log utility (derived
Pc i
in class and on Problem Set 10): t t = t (again, note that the preference shifter Bt does
M t 1 + it
not appear). A surprise rise in M in the RBC view is met with an adjustment in just (all)
prices, since the choice regarding consumption represents an optimal choice. Thus P rises.
But in the above diagram, the slope is W/P (the nominal wage divided by the nominal price
level). In order to leave the planned optimal consumption choice unaffected, the slope of the
budget line must remain the same, which requires that W rises by the same percentage as the
rise in P. Graphically, then, nothing changes: the budget line is unaffected, and optimal
choice remains unchanged.

4
Problem 2 continued
c. (7 points) Consider again the same money shock from part b. Suppose the nominal wage is
completely rigid (i.e., it can never change), but nominal goods prices are completely
flexible. In the diagram below, sketch the effects on the consumer’s optimal choice of
consumption and leisure in period t due to the surprise extra quantity of money in the
economy. Clearly label your diagram, and explain precisely any and all effects pertinent
here. (Hint: The consumption-money optimality condition is relevant for the analysis here.)
consumption

Solution: The logic proceeds as in part c until the discussion about the nominal wage. In order
to leave the consumption choice unchanged, we saw in part c that W had to rise by the same
percentage as P. But here W is sticky, so the budget line must rotate somehow. With a rise in P
and W unchanged, the real wage is lower, so the budget line pivots downward, meaning optimal
consumption is lower here. Thus, in this case expansionary monetary policy ends up causing
consumption to fall because of the stickiness in nominal wages.

d. (4 points) The RBC view is captured by which scenario, part b or part c? The New
Keynesian view is captured by which scenario, part b or part c?

Solution: The RBC view is part b (all prices are flexible), the NK view is part c (some prices –
in this case wages – are sticky).

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Problem 3. Consumption, Savings, and Financing Constraints. (35 points) Because the
consumption expenditures that occur later in an individual’s lifetime are typically on “bigger-
ticket items” (e.g., cars, refrigerators, etc.) and thus more expensive, an individual often has to
begin planning for his/her future consumption expenditures well in advance of their actual
purchase and use. In contrast, consumption expenditures during the earlier years of an
individual’s life are predominantly on “smaller” items (e.g., movies, food, entertainment, etc.)
and thus might not require as much “advance planning.”

We can analyze this idea in a two-period representative consumer framework. As always,

suppose the representative consumer has utility function of period-1 consumption and period-2
consumption given by u (c1 , c2 ) . Naturally, period 1 is the “early stage” of an individual’s
economic life, and period 2 is the “later stage” of an individual’s economic life.

Suppose the financial assets that individuals have at their disposal are “stocks,” just as we
studied in Chapter 8. The representative consumer begins period 1 with zero stock holdings (i.e.,
a0 = 0). The period-1 and period-2 budget constraints of the representative consumer are thus

1 1 + S1a1 = Y1
Pc
P2 c2 + S2 a2 = Y2 + ( S 2 + D2 )a1

in which the rest of the notation is as always: P denotes the per-unit nominal price of a
consumption good (in a given time period), Y denotes the nominal income the consumer earns (in
a given time period), S denotes the nominal price of each share of stock (in a given time period),
and D denotes the per-unit nominal dividend each share of stock pays (in a given time period).

Because period-2 goods are weighted more towards “big-ticket items,” consumers typically have
to borrow to purchase them. This means that asymmetric information issues may be a factor in
lenders being willing to extend credit to consumers for their period-2 purchases. Suppose the
financing constraint (aka credit constraint) that has evolved in markets to deal with these
information issues is

P2 c2 = S1a1 .

The interpretation of this constraint is that the market value of assets accumulated during period
1 of the individual’s life forms the basis for period-2 consumption. Finally, just as in class,
define the “nominal interest rate on stock” as

S2 + D2
1 + i STOCK = ,
S1

1 + i STOCK
define the “real interest rate on stock” as 1 + r STOCK
= , and, because this is a two-period
1+ π2
framework, we know a2 = 0. (OVER)

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Problem 3 continued
a. (6 points) Formulate the sequential Lagrangian for the representative consumer’s utility
maximization problem, starting, as usual, from the perspective of the beginning of period 1.
(Several hints and notes are useful here: i) Do not substitute the financing constraint directly
into any of the other constraints; it will be most informative to conduct the analysis with the
financing constraint as a separate constraint; ii) Use the multiplier μ (the Greek letter “mu”)
for the financing constraint; iii) Be extremely careful about your setup of the Lagrangian
here, because it is the basis for almost all of the analysis that follows!)

Solution: The sequential Lagrangian is

1 1 − S1a1 ] + λ2 [Y2 + ( S 2 + D2 ) a1 − P2 c2 ] + μ [ S1a1 − P2 c2 ]

u (c1 , c2 ) + λ1[Y1 − Pc

b. (8 points) Based on the Lagrangian in part a, compute the first-order conditions with respect
to c1, c2, and a1.

Solution: The FOCs are

u1 (c1 , c2 ) − λ1 P1 = 0
u2 (c1 , c2 ) − λ2 P2 − μ P2 = 0
−λ1S1 + λ2 ( S2 + D2 ) + μ S1 = 0

For use in the next parts of the problem, note that the first equation can be rearranged to
u (c , c ) u (c , c )
λ1 = 1 1 2 ; the second equation can be rearranged to λ2 = 2 1 2 − μ ; and the third
P1 P2
⎛ S + D2 ⎞
equation can be written as λ1 = λ2 ⎜ 2 ⎟ + μ , or using the definition of the “interest rate on
⎝ S1 ⎠
stock,” λ1 = λ2 (1 + i STOCK ) + μ .

7
Problem 3 continued
c. (4 points) If there were no financing constraint on consumers’ purchases of period-2
consumption, the value of the Lagrange multiplier μ could be thought of as being equal to
what numerical value? Be as precise as possible, and briefly explain. (Note: You can
answer this part even if you were unable to get all the way through part a and part b.)

Solution: If financing conditions did not matter at all for consumption purchases, we could
think of the value of the Lagrange multiplier on the financing constraint as being exactly equal to
zero.

S2 + D2 1 + i STOCK
d. (10 points) Using the definitions 1 + i =
STOCK
and 1 + r STOCK
= , rearrange
S1 1+ π 2
the first-order conditions you obtained in part b above to derive the consumption-savings
u (c , c )
optimality condition. Your final expression should be of the form 1 1 2 = ... , where the
u2 (c1 , c2 )
ellipsis on the right hand side indicate terms that you must determine. Clearly explain/show
the steps in your logic/derivation. (Note: It is fine if the final expression contains the
multiplier μ in it. This derivation requires a few algebraic steps, but the logic of the
derivation is exactly the same as our initial study of the two-period framework.)

Solution: Inserting the expressions for λ1 and λ2 obtained in part b above into the third
expression obtained in part b above, we have
u1 (c1 , c2 ) u2 (c1 , c2 )(1 + i STOCK )
= − μ (1 + i STOCK ) + μ .
P1 P2
On the right hand side, we can cancel μ, leaving us with
u1 (c1 , c2 ) u2 (c1 , c2 )(1 + i STOCK )
= − μi STOCK .
P1 P2
On both sides of this expression, multiply by P1 and divide by u2 (c1 , c2 ) to get
u1 (c1 , c2 ) P1 (1 + i STOCK ) μ Pi STOCK
= − 1
.
u2 (c1 , c2 ) P2 u2 (c1 , c2 )
Using the Fisher relation, we could also express this as
u1 (c1 , c2 ) μ Pi STOCK
= 1 + r STOCK − 1
u2 (c1 , c2 ) u2 (c1 , c2 )

Either of the latter two expressions are written in the requested form. Note that if μ = 0, this is
simply MRS across time periods is equal to the gross real interest rate (where the interest rate is
that measured according to stock-market returns).

8
Problem 3 continued
e. (7 points – Harder) Based on the consumption-savings optimality condition you derived in
part d above, does the financing constraint P2 c2 = S1a1 “matter” for consumer’s consumption
and savings decisions over time? In other words, does the “standard” consumption-savings
optimality condition studied in Chapter 3 and 4 get altered by the presence of this financing
constraint? If so, explain the economic intuition behind why; if not, explain the
economic intuition behind why not. (Hint: A diagrammatic explanation, although not
required, may be useful. In any case, there are likely several different ways to usefully
describe the economic effects here.)

Solution: Clearly, if μ is different from zero, the “standard” consumption-savings tradeoff is

affected. To gain intuition for how/why, we can re-express the condition in part d as

u1 (c1 , c2 ) + μ Pi STOCK
1
= 1 + r STOCK .
u2 (c1 , c2 )

Here, the left-hand-side is a sort of “generalized MRS” (note that the term μ Pi 1
STOCK
has units of
utils because μ has units of utils/dollar). If μ = 0, then clearly we have the usual Chapter 3 and 4
optimality condition. Imagine drawing the corresponding indifference curve/lifetime budget
constraint diagram of this outcome.

Then, starting from the unconstrained optimal choice, if the value of μ rises above (falls below)
zero, then, holding constant the real return on stock (i.e., holding constant the slope of the LBC),
the indifference curve passing through the unconstrained allocation becomes steeper (flatter).
The new optimal choice (i.e., the one taking into account the binding financing constraint) then
features more (less) c1 (and thus less (more) c2) compared to the unconstrained optimal choice.

Thus, in this case, consumers can be “forced” to consume either more or less consumption
across time periods due to the financing constraint. This seems at odds with our discussion of
credit constraints earlier in the semester. The difference arises because here we are considering
an always-binding financing constraint (i.e., it always holds with strict equality), whereas in
our earlier study we were considering a credit constraint that only affected consumption-savings
outcomes if consumers wanted to borrow during period 1 but not otherwise.

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Problem 4. Proportional Taxes and Ricardian Equivalence? (20 points) (Harder) Consider
a modified version of the two-period framework with government studied in Chapter 7. By
“government” here we will mean just the “fiscal authority;” suppose there is no “monetary
authority” at all.

The government and the representative consumer each live for both periods of the economy, and
suppose there are never any credit constraints on the consumer. The government does not have
access to lump-sum taxes, only proportional consumption taxes. However (this is different from
our baseline framework), the consumption taxes the government collects in a given period are
not restricted to be levied on consumption from only in that period.

To be more precise, suppose that total consumption tax revenues the government collects in
period 1 are based only on period-1 consumption (because there was no period zero, say).
However, total consumption tax revenues the government collects in period 2 are based on both
period-1 consumption and period-2 consumption. That is, a portion of the revenue collected in
period 2 is based on period-1 consumption, and the remaining portion of the revenue collected in
period 2 is based on period-2 consumption.

Denote by τ 1,1 the tax rate on period-1 consumption that is levied in period 1; denote by τ 1,2 the
tax rate on period-1 consumption that is levied in period 2; and by τ 2,2 the tax rate on period-2
consumption that is levied in period 2. There is no τ 2,3 (which would represent the tax rate on
period-2 consumption that is levied in period 3) because the economy does not exist in period 3.

With this notation, the government’s period-1 and period-2 budget constraints in real terms are:

g1 + b1 = (1 + r )b0 + τ 1,1c1
g 2 + b2 = (1 + r )b1 + τ 1,2 c1 + τ 2,2 c2

The representative consumer’s period-1 and period-2 budget constraints in real terms are:

(1 + τ 1,1 )c1 + a1 = (1 + r )a0 + y1

τ 1,2 c1 + (1 + τ 2,2 )c2 + a2 = (1 + r )a1 + y2

For simplicity, suppose the government and consumer each begin period 1 with zero assets. As
usual, you can think of all the tax rates as being numbers between zero and one (but they need
not be so restricted). The remainder of the notation is as in class.

Note carefully how the tax rates τ 1,1 , τ 1,2 , and τ 2,2 appear in these budget constraints.

(OVER)

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Problem 4 continued
a. (5 points) Construct the government’s LBC, showing important steps. Provide brief
economic interpretation.

Solution: The way to construct the government LBC is the same as always: first solve the
period-2 budget constraint for b1 (in which we use the usual condition b2 = 0), then insert this
solution into the period-1 constraint. Rearranging terms a bit, we arrive at
g τ c τ c
g1 + 2 = τ 1,1c1 + 1,2 1 + 2,2 2 ,
1+ r 1+ r 1+ r
which states, as does any government LBC, that the present-value of lifetime government
spending equals the present-value of lifetime government tax collections. Here, those lifetime
tax collections involve taxes on period-1 consumption that are collected in period 1 (the τ 1,1c1
term) as well taxes on period-1 consumption that are collected in period 2 (the τ 1,2 c1 term), which
must be discounted because it is collected in period 2.

b. (15 points) The essence of the way we defined Ricardian Equivalence in class was:

An economy exhibits Ricardian Equivalence if, holding fixed

its sequence of government spending, a change in the timing
of lump-sum taxes (and also assuming no credit constraints
and that consumers’ planning horizons are the same as the
government’s planning horizon) has no effect on consumption
or national savings.

In the analysis at hand here, suppose the government keeps its sequence of g1 and g 2
unchanged, but decides to cut the tax rate in period 1 on period-1 consumption – that is, it
lowers the tax rate τ 1,1 . Is it possible for this economy to exhibit Ricardian Equivalence even
though in the framework in this problem taxes are NOT lump-sum? If so, carefully show
how/why and provide brief economic interpretation. If not, precisely explain why not. (Hint:
Derive the consumer’s LBC and focus your attention on the slope of the consumer’s LBC.)

Solution: To begin, construct the LBC of the consumer in the usual manner. Solve the period 2
budget constraint for a1 (using the No-Ponzi condition a2 = 0 ) to get
τ 1 + τ 2,2 1
a1 = 1,2 c1 + c2 − y2 . Insert this into the period-1 budget constraint – doing so and
1+ r 1+ r 1+ r
rearranging a bit gives us
τ 1 + τ 2,2 y
(1 + τ 1,1 )c1 + 1,2 c1 + c2 = y1 + 2 .
1+ r 1+ r 1+ r
Let’s combine the terms involving c1 to get

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 ⎡ τ 1,2 ⎤ 1 + τ 2,2 y2
⎢1 + τ 1,1 + 1 + r ⎥ c1 + 1 + r c2 = y1 + 1 + r .
⎣ ⎦
Solve this for c2 :
⎛ τ 1,2 ⎞
⎜ 1 + τ 1,1 + 1 + r ⎟ (1 + r ) y1 + y2 ,
c2 = − ⎜ ⎟ (1 + r ) c1 +
⎜⎜ 1 + τ 2,2 ⎟⎟ 1 + τ 2,2 1 + τ 2,2
⎝ ⎠
and, as you’re told, focus on the slope of the LBC, i.e., the coefficient in front of c1 . Before we
proceed, let’s outline the rest of the argument. Ricardian Equivalence is a statement about how
changes in taxes do (or do not) lead to changes in national savings, which, recall, is
s1nat = y1 − g1 − c1 in period 1. As we’ve discussed, the issue then boils down to determining
whether a change in taxes affects period-1 consumption (because y and g are assumed to be
unchanging in period 1).

In the (simpler) framework with proportional consumption taxes we studied in class, we had
(implicitly) that τ 1,2 = 0 , which means that period-1 consumption decisions did not lead to tax
payments in period 2. Thus, in that framework, a fall in τ 1,1 would mean that τ 2,2 must rise in
order for the government LBC to hold – the fall in τ 1,1 and the rise in τ 2,2 necessarily means the
slope of the LBC in that framework became flatter, which then in general would mean that the
optimal choice of c1 would change, which would thus mean that national savings changes, hence
Ricardian Equivalence does not hold.

However, here τ 1,2 can be nonzero. It is possible that, when τ 1,1 falls, τ 1,2 could rise by an
amount that leaves the overall coefficient in front of c1 , which is after all the slope of the LBC,
unchanged. If the LBC doesn’t change, then the optimal choice of consumption doesn’t change,
hence national savings doesn’t change, hence Ricardian Equivalence holds even though taxes
are not lump-sum here and none of the other reasons for the failure of Ricardian Equivalence
are present either.

Allowing for the government to tax past choices (that is, allowing the government to tax in
period 2 consumption which occurs in period 1) through non-lump-sum taxes turns out to
resuscitate the Ricardian Equivalence Theorem here. A bit more specifically, what’s happening
in this framework is that the government has a richer tax structure available to it compared to the
proportional-tax framework we studied in class – the government is not restricted here to tax
only contemporaneous choices in a given period. The taxes paid in period 2 according to the rate
τ 1,2 were incurred in period 1; it’s just that they are not paid until period 2. It turns out that it
does not matter exactly when the taxes incurred in period t are paid – they can be paid at any
time, and the timing of those tax collections don’t affect real economic activity.

12
Problem 4 continued
This result is only a recently-understood one in theoretical macreconomics, even though the idea
of Ricardian Equivalence has been a benchmark result in macroeconomic theory for the past 30
years.1

END OF EXAM

1
See Marco Bassetto and Narayana Kocherlakota, “On the Irrelevance of Government Debt When Taxes are
Distortionary,” Journal of Monetary Economics, Vol. 51, 2004, p. 299-304, for the first exposition of this result, a
very readable article, one which in fact is developed using the simple two-period model.

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